Using Accounting and Financial Records as Evidence

By Michael J. Molder, Senior Manager - Advisory Service

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If business entities, whether for-profit or not-for-profit, were living creatures, we could view the various functional groups as body parts. The executive or management offices are the brain and nervous system, the production facilities are the hands, warehousing and shipping are the intestines and … well, you get the picture. Following this analogy, the controllership or accounting function is the business circulatory system, supporting the other functions and distributing information among the various segments. In some form or another, information about activities throughout the far-flung reaches of the enterprise pass through the accounting department where it is filtered, sorted and re-directed to other parts of the business.

In personal injury cases, accounting data can provide information which forms the basis for punitive damages;

In divorce cases, accounting data can show how the opposing party is siphoning funds out of a closely held business which is part of the marital estate;

In shareholder litigation, accounting data can show how management or majority owners are breaching their fiduciary duties toward minority shareholders, manipulating financial disclosures or understating the value of the minority shares in a merger or corporate transaction;

In a breach of contract action, either side can use the opponent’s accounting data to assess claims of damages related to the alleged breach, and

In almost any litigation where there is an issue of piercing the corporate veil, accounting data is vital to establishing either the claim or the defense to it.

Ultimately, accounting data, in one form or another, and an understanding of the financial records are relevant to practically any litigation involving one or more commercial entities.

Identifying & Obtaining Vital Documents

The facts and types of documents needed will vary with the type of case involved. By way of example, Harry is a high volume sales representative at AB Coatings, Inc., a manufacturer of high tech paints and other finishing products. Over the years, Aldeforth Billingsley, the company founder, gave Harry shares of stock to reward his loyalty and ensure it continued. Several years ago, Charles, Aldeforth’s nephew, inherited his uncle’s interest in the company. When the litigation begins, Harry owns 10% of the company stock.

If the litigation relates to Harry’s divorce, the value of those shares, as part of the marital estate, may be critical. Since Harry is a minority shareholder with limited access to internal company operations and virtually no ability to influence the allocation of resources within the company, valuing Harry’s shares for purposes of equitable distribution will likely only require basic financial statements and, if available, forecasts of future operations.

If, on the other hand, the litigation involves allegations that Charles has been systematically looting and mismanaging the company, establishing the plaintiff’s case, or defenses to it, will require a deeper investigation into the finances of the business. In this kind of case, individual cash disbursements may be important, or a detailed analysis of payroll to determine if there are phantom employees on the books.

The scope of financial records sought in discovery, and the validity of those requests, will depend on the evidence required to support or challenge the allegations. There is no standard set of discovery requests for accounting records which will serve for all cases. An accounting expert can play a key role in helping counsel determine what facts will establish a particular claim or defense and identifying the documents needed to prove that particular claim or defense. The accountant’s expertise can be invaluable in the process of identifying information or records, which may lead to a better understanding of the case, and to winnowing through the evidentiary records to what is likely to be most productive at trial.

One preliminary issue counsel must resolve is whether to utilize the services of the client’s existing accounting professional or to retain a consultant experienced in forensic accounting. The issue is fraught with a variety of strategic and other concerns, including the balance of economy (the existing accounting professional starts with a fundamental understanding of the client and its financial systems) and exposure (the existing accounting professional may also have knowledge of matters counsel would prefer not become a part of the evidentiary record). Separate from these strategic issues, the forensic accountant may prove more helpful than the existing general accounting professional in identifying financial data and documents which will be useful in the presentation of the client’s case. In addition to the general background of accounting, auditing and or tax services, the forensic accountant, typically, has accumulated substantial experience in litigation. As a result, the forensic accountant, whether an experienced “testimonial” expert or a “consulting-only” expert, can help counsel focus on evidence relevant to proving legal issues and filter extraneous information.

Counsel should develop a preliminary strategy or outline for the case to assist the expert in narrowing the issues so the expert can determine what documents to review or what questions to ask in order to develop the necessary record. For example, in matrimonial cases, the primary financial concerns involve the parties’ respective income available for support and the equitable distribution of the marital estate. Depending on the employment situation, income can be straight-forward wages, but there may also be ownership interests, stock options or elements of non-cash compensation. Alternatively, if one of the parties is self-employed, there is a potential that the business is paying personal expenses or that it has deferred or otherwise not recognized all of its revenue. These situations call for distinctly different analyses and documentation requirements. Counsel should obtain, either from the client or through preliminary disclosures, the basic financial information relevant to the case even before consulting an accounting or financial expert. This information can come in the form of financial statements (with or without an independent accountant’s report) or tax returns – preferably both.

Looking beyond the basic financial information, organizations keep a whole host of data which can be useful to a litigant. While different kinds of data are better suited, or more appropriate, to particular kinds of analysis – and therefore needed for different kinds of claims – as a general rule, the closer the data is to the source, the more useful and reliable it is. It is the rare case, indeed, where less data is better. Most practicing forensic accountants have access to software for data analysis. This software, ranging from electronic spreadsheet programs commonly included in commercially available business productivity suites to highly sophisticated data mining tools and proprietary packages, works most efficiently and effectively with large volumes of data from original sources. With these tools, a financial analyst can detect trends and deviations from trends which are often the critical evidence of a claim.

Also, it is important to think creatively about the kinds of accounting information to request. Often, small businesses don’t have audited financial statements – if they have financial statements at all. A request for financial reports usually results in a production of federal tax returns which, alas, are less reliable, the smaller the business. In this situation, alternative reporting systems can provide more reliable financial data. Alternative reporting systems include sales and excise tax returns, franchise reports, insurance policy applications and renewals.

A forensic accountant is an accounting professional whose practice focuses on “forensic accounting.” There is no single definition of the term “forensic accounting,” however the American Institute of Certified Public Accountants (AICPA) describes it as “the application of special skills in accounting, auditing, finance, quantitative methods, certain areas of the law and research, and investigative skills to collect, analyze, and evaluate evidential matter and to interpret and communicate findings.” (“Forensic Services, Audits, and Corporate Governance: Bridging the Gap, Discussion Memorandum” prepared by the AICPA Forensic and Litigation Services Committee and Fraud Task Force, July 15, 2004.)

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